Question

Which of the following is a reason municipal bonds offer lower rates of interest income for their investors? Select one: A. They are able to avoid interest rate risk. B. They are tax exempt - at least at the federal level. C. They are able to offer reduced credit risk as they are backed by the federal government. D. They are able to avoid reinvestment rate risk. A two-year Treasury security currently earns 5.25 percent. Over the next two years, the real interest rate is expected to be 3.00 percent per year and the inflation premium is expected to be 2.00 percent per year. What is the maturity risk premium on the two-year Treasury security? Select one: O A. 0.25 percent O B. 1.05 percent O C. 1.00 percent D. 5.00 percent

Answer 1

a.) Option B is correct: They are tax-exempt at least at the federal level.

Municipal bonds can afford to have a lower rate because the interest paid on these bonds is always exempted from federal taxes (sometimes for state and local taxes as well).

b.) Option a is correct.

The maturity risk premium is an addition to the given rate to cover up for the posiibiloty that issuer do not meet their obligation related to maturity.

yield = real interest rate + inflation rate + maturity risk premium

5.25 = 3 + 2 + maturity risk premium

maturity risk premium = 0.25% Answer